Short & Simple 17 – A Notion of Macroeconomic Equilibrium

Equilibrium is conceived as a position of stability at which the plans of economic agents (for example, households and firms) are ‘realized’ or compatible, so that there is no incentive to alter current behavior.

At the macro level, equilibrium requires that the sum of total planned expenditures (‘demand’) equals the aggregate level of output (‘supply’).

Equilibrium could occur at high or low levels of output and employment. It would not ensure full employment.

We have previously encountered the national accounting identity:

Total Output = Total Spending

In symbols:

Y = C + I + G + X – M

This identity does not imply equilibrium.

To understand why, recall that the identity follows from the way private investment is defined. Investment includes changes in inventories (unsold output). A change in inventories can be intentional or a mistake.

If firms sell what they expect, any change in inventories will be planned (or desired). However, if sales differ from the expected level, there will be an accumulation or depletion of inventories that is unanticipated (or unplanned or undesired).

For theoretical purposes, it can be useful to distinguish between planned and unplanned investment. This enables us to distinguish between equilibrium and disequilibrium situations. This distinction can be useful because it has ramifications for future behavior. Disequilibrium will encourage a change in behavior. Equilibrium will encourage a continuation of current behavior (unless there are known reasons to expect things to change in the future).

In making the distinction, ‘actual investment’ can be defined to include both planned and unplanned elements. ‘Planned investment’ differs from actual investment in that it excludes unanticipated changes in inventories. Unanticipated changes in inventories constitute ‘unplanned investment’:

Actual Investment = Planned Investment + Unplanned Investment

In symbols:

I = IP + IU

Unanticipated changes in inventories (IU) relate closely to equilibrium and disequilibrium.

Unexpectedly high inventories (IU > 0) are the result of excess supply. The unanticipated change in inventories is evidence that actual output (aggregate supply) exceeds planned spending (aggregate demand). For example, if firms expect to sell $100 billion of output but only sell $98 billion, there will be unplanned investment of $2 billion and an excess supply of the same amount.

Conversely, unexpectedly low inventories (IU < 0) are the result of excess demand. Inventories deplete as firms run down stocks to meet the unexpectedly strong demand.

It is still always true that actual output equals actual spending (Y = C + I + G + X – M). But whenever unplanned investment differs from zero, actual output will differ from planned spending. If we call actual spending AE (for ‘aggregate expenditure’) and planned spending AEP, we have:

Y = AE = C + IP + IU + G + X – M

AEP = C + IP + G + X – M

Equilibrium requires:

Y = AEP = C + IP + G + X – M

This only occurs when IU = 0.

Strictly speaking, all categories of spending involve planned and unplanned components. For example, households might consume less (save more) than intended because of a temporary shortage of output or interruption in production. Government might intend to spend a certain amount on public hospitals but confront a temporary shortage of qualified staff or materials. And so on. For simplicity, we will assume that most spending is at its planned level and any divergence of aggregate supply from aggregate demand is the result of unplanned investment.

The distinction between planned and actual spending is relevant to the idea of demand-determined output. In the previous post, it was supposed that output depends on autonomous spending (including private investment) and the marginal propensity to leak. Strictly speaking, the level of output that is determined by demand, in this framework, is the equilibrium level, not the actual level.

Call equilibrium output Ye, planned autonomous expenditure AP and the marginal propensity to leak α. Then:

This says that equilibrium output is a particular multiple (1/α) of planned autonomous spending.

In situations of disequilibrium, firms are assumed to respond to excess demand or supply by altering the level of production in an attempt to eliminate unplanned investment.

This behavior will tend to bring output toward the equilibrium level. It is only in equilibrium that firms would have no reason to change behavior.

It perhaps should be emphasized that equilibrium can be thought of in relation to the level of output or the growth rate.

In reality, growth is the normal situation. In an economy that grows on average, a “continuation of current behavior” would mean an expansion of production in line with the current rate of growth. A “change in behavior” would mean an acceleration or deceleration in the rate of growth.

In the present context, we are considering production within a given period. Accordingly, the definition of equilibrium relates to the level of output. But the emphasis would need to change to the economy’s growth rate when considering how the level of production changes over time.